Penny stocks: Safety and risk

Most people in the financial world consider larger companies to be safer investments, and for the most part they are correct. Because companies tend to grow in size as they become successful (as expressed by a higher share price and larger market cap), the bigger they get, usually the more stable their position. In contrast, newer, smaller, or less-successful companies generally see their stock trading for low prices. From this perspective, penny stocks are typically riskier or lower-quality investments than larger companies.

The risk and perceived lack of safety associated with penny stocks are what create the opportunities for penny stock investors to reap substantial rewards. If they weren’t risky, penny stocks wouldn’t trade as penny stocks at all, but would instead be priced at much higher levels.

Investors who can identify and accept areas of concern for a company, or anticipate improvements in those risk factors, can find numerous values among low-priced shares.

Opportunity exists for those penny stock investors who can:

1. Accept the risk.As long as you’re aware of the greater perceived risk and are willing to accept it in exchange for the potential of greater returns, you can find numerous opportunities among penny stocks.

2.Find overblown risk perceptions.When investors are overreacting to a company’s risk factors, they may greatly undervalue the shares. Investors who recognize that the concerns are overblown can accumulate shares at very low prices. For example, if a drug development company with 12 products fails to get FDA approval for one of them, the shares often collapse in response. But investors who remember that the company has another 11 drugs in development will scoop up the shares for a fraction of what they’re actually worth.

3.Identify shrinking degrees of risk.Often the risk factors keeping the shares of a company down eventually abate or change for the better. Usually there is a delay of weeks or months between when circumstances improve for the company and the resulting share price increases. That delay represents an opportunity for investors to invest in a penny stock that’s being held down by perceived risk that’s no longer a factor.